JC Penney: The Next Front in the Icahn Vs. Ackman Spat?

The struggling retailer received a nasty surprise from a group of its bondholders last week.

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JC Penney (NYSE:JCP) shares have sunk 53% since February 1, 2012, the day the company brought in its new "Fair and Square" prices policy.

Under the plan, spearheaded by recently hired CEO Ron Johnson, who is best known as the creator of Apple's (NASDAQ:AAPL) retail stores, JC Penney did away with its ubiquitous coupon sales and went with an "everyday low prices" policy. The thinking was that customers would come into the store more often instead of waiting for a sale; it's an approach that has been used to great effect by a number of other retailers, most notably Wal-Mart (NYSE:WMT).

"Coupons were a drug, they really drove traffic," Johnson said at the time.

But going cold turkey doesn't appear to be the tonic that the 110-year-old chain needed. The move has instead pushed customers to look elsewhere for the deals they used to get from JC Penney-or shop at online retailers like Amazon.com (NASDAQ:AMZN).

In the first quarter after JC Penney announced the move, sales dove 20.1% from a year earlier, and the company posted an adjusted loss of $55 million, or $0.75 a share. The damage continued in the next quarter, with sales dropping 22.6% and Penney's loss widening to $81 million, or $0.37 a share. And in the company's latest quarter, which ended October 27, 2012, the hill got steeper: Sales slumped 26.6%, and adjusted loss ballooned to $203 million, or $0.93 a share.

JC Penney Reverses Course

Stung by the losses, JC Penney has recently begun to reverse course. The creep back toward coupons started with the company's Black Friday sale, under which JC Penney mailed customers a $10 "gift" to use at the stores.

"This invitation is in no way a reflection of a departure from our Fair and Square everyday low prices," JC Penney spokesperson Kate Coultas wrote in an email to the Associated Press at the time.

Now, JC Penney has announced that it will offer other sales tied to certain times of the year. Right now, for example, it is offering discounts on jewelry in the run-up to Valentine's Day.

JC Penney Bondholder Group Could Make Life Miserable

As if this weren't enough, the company now faces a challenge from a group of its bondholders. On February 4, JC Penney received a letter from law firm Brown Rudnick that accused it of breaching a covenant of its bond indenture agreement by putting up store inventory as collateral for a line of credit it took out in January 2012.

The firm claimed to represent more than 50% of holders of the company's 7.4% bonds due in 2037. In all, these investors hold about $326 million of debt. However, the letter alleges that the company could be in breach of this covenant for all of its $2.9 billion of long-term debt. The letter also said the bondholders believed that, as a result of this alleged action, all the company's debt could become payable in less than three months-something that would almost certainly drive it out of business.

JC Penney has since filed a lawsuit to stop the group from declaring a default on the bonds. "We believe this notice of default is invalid, completely without merit and is intended to create self-interested trading opportunities in the market, and we will therefore vigorously defend the interests of JC Penney and all of our constituencies," CFO Ken Hannah responded in a statement quoted by Bloomberg.

Enter the Hedge Fund Honchos

Adding to the intrigue is the fact that activist investor Bill Ackman's Pershing Square Capital Management is Penney's largest shareholder, with a 17.8% stake.

Ackman has made headlines lately by very publicly duking it out on CNBC with fellow hedge fund manager Carl Icahn after Ackman recently revealed his 20-million-share short position in nutritional supplement maker Herbalife (NYSE:HLF). Ackman had previously called Herbalife a "pyramid scheme" whose stock price was headed to zero, to which Herbalife CEO Michael Johnson responded by calling Ackman's comments a "bogus accusation" and "blatant market manipulation."

The CNBC debate between Ackman and Icahn was a colorful affair that will not be soon forgotten. In it, Icahn repeatedly referred to Ackman as "this Ackman guy," and called him a "crybaby in the schoolyard." Ackman responded by laying out in detail his past dealings with Icahn and calling him a "bully" and "a guy who takes advantage of little people."

The Herbalife affair is at the heart of the soap opera: Icahn and other wealthy investors have bet against Ackman by going long on the stock. That could put Ackman in a "short squeeze" if the share price moves higher, forcing the short sellers, including Ackman, to cover their positions.

The episode goes well beyond Ackman and Icahn: On January 9, Daniel Loeb of Third Point Investments revealed that his hedge fund held 8.2% of Herbalife-a stake worth $350 million, according to the Wall Street Journal. There has also been speculation that Third Point once shorted JC Penney.

All this history, along with a number of other factors, caught the attention of the Zerohedge.com website, which published a February 4 article pointing out that the timing of the bondholders' letter (January 29) came just after the CNBC dust-up between Ackman and Icahn. That's particularly suspicious, argues Zerohedge, in light of the fact that JC Penney took out the line of credit in question over a year earlier. In addition, the Zerohedge article pointed to a sharp jump in trading volume for JC Penney 2037 debentures on January 25, the very day of the CNBC confrontation. There are other connections, too. For example, Icahn is also a Brown Rudnick client.

"All of the above is, for now, conjecture," writes the site. "But it just fits too perfectly: the timing, the approach (so typical of the old school Icahn), and the target: because nothing would crush 'retail expert' Ackman, who is openly feuding with Icahn over Herbalife, as a JC Penney bankruptcy. And nothing would bring greater validation to Icahn's claim that he 'does not respect Ackman as an investor,' uttered during the infamous January 25 debate."

New Concept Has Legs-But Current Troubles Could Trump It

None of this does much to inspire confidence in the stock. Despite its troubles, however, there are some signs of life in the company.

For example, Johnson's plan to convert JC Penney into a collection of "stores within stores" is gaining traction. The plan started with Sephora beauty boutiques in 2007, and the company is also setting up outlets for Levi's, Martha Stewart, and the Canadian Joe Fresh fashion brand.

The concept is performing well so far: Johnson has said the Sephora boutiques have produced 5% same-store sales increases "independent of the JC Penney performance."

The problem? Johnson may be running out of time: the company plans to complete the rollout in 2015. That may be just too late for both Penney and its bondholders.